This Just In: More Upgrades and Downgrades

At The Motley Fool, we poke plenty of fun at Wall Street analysts and their endless cycle of upgrades, downgrades, and "initiating coverage at neutral." While the pinstripe-and-wingtip crowd is entitled to its opinions, we've got some pretty sharp stock pickers down here on Main Street, too. (And we're not always impressed with how Wall Street does its job.)

Given that, perhaps we shouldn't be giving virtual ink to "news" of analyst upgrades and downgrades. And we wouldn't -- if that were all we were doing. Fortunately, in "This Just In," we don't simply tell you what the analysts said. We also show you whether they know what they're talking about. To help, we've enlisted Motley Fool CAPS, our tool for rating stocks and analysts alike. With CAPS, we track the long-term performance of Wall Street's best and brightest -- and its worst and sorriest, too.

Like peanut butter and chocolate
It had all the hallmarks of a Reese's commercial. When Goldman Sachs endorsed Johnson & Johnson (NYSE: JNJ  ) yesterday, investors smiled like the first kid who ever dipped chocolate in his peanut butter. This upgrade was truly two great companies, and they "tasted great together."

It was actually a busy day for pharma picks at Goldman, which in addition to J&J also recommended that investors dip into shares of Stryker (NYSE: SYK  ) and Becton, Dickinson (NYSE: BDX  ) . But the analyst was particularly optimistic about J&J. Said Goldman: "Johnson & Johnson drugs like Zytiga, Xarelto, and Incivek will lead the way to better performance from its pharmaceutical business."

Meanwhile, results at the company's medical devices and diagnostics division have "stabilized." True, "dozens" of product recalls have hurt J&J's vaunted consumer business ("I am stuck on Band-Aid brand, 'cause Band-Aids stuck on me...") But ignoring the warning signs, Goldman calls this a contrarian indicator that this unit has finally bottomed. In short, now that things are so bad, they can't possibly get any worse.

Or can they?

Let's go to the tape
Please understand, I don't question Goldman's recommendation lightly. According to our CAPS stats, this top-15%-ranked investor is truly one of the best health-stock-pickers out there, boasting a record of 61% accuracy on its Health care Services recommendations, and 67% in Biotech. On the other hand, Goldman's weakest record in the health-o-sphere is in Pharmaceuticals. Although it's gotten 58% of its picks right in the industry, Goldman nonetheless lags the S&P 500's performance thanks to a series of hi-profile blowups at the likes of Salix (Nasdaq: SLXP  ) , Teva (Nasdaq: TEVA  ) , and Perrigo:

Company

Goldman Rating

CAPS Rating
(out of 5)

Goldman's Picks Lagging
S&P by

Salix

Outperform

***

35 points

Teva

Outperform

*****

32 points

Perrigo

Underperform

***

42 points

Tempting fate
Clearly, even Goldman's not perfect at picking pharma stocks. In illustration of which, no sooner had its upgrade come down than newswires began filling with stories of yet another recall at J&J -- this time for a "musty odor" emanating from several lots of the company's Prezista HIV medication. So not even a consumer product recall, but a pharma-gaffe.

Call it bad luck, call it a bad omen. When I saw that news, it just called my attention to the possibility that Goldman might have goofed again when recommending Johnson & Johnson. So rather than take the recommendation at face value, what did I do? I looked that the numbers. Here's what I found:

Right now, Johnson & Johnson shares fetch about 15 times earnings on the market. Not a high price, you might think. But when you consider that the company is only expected to grow its earnings at about 6% per year over the next half-decade, a 15 P/E does begin to look a bit rich. Sure, the company might grow faster than expected, and yes, its 3.5% dividend will help take the sting out in the event J&J only meets expectations. On the other hand, I'm not thrilled at what I'm seeing happen on J&J's cash flow statement these days. JJ generated all of $1.9 billion in free cash flow from its business in Q1, or barely half the amount of cash it spun off in the year-ago quarter. It's not a huge problem, but it's still worrisome, and requires careful monitoring in the future.

Foolish takeaway
Personally, I prefer to invest in companies like Merck (NYSE: MRK  ) and AstraZeneca (NYSE: AZN  ) , both of which reported improved free cash flows in their most recent quarter. (In fact, I recently bought shares of Astra precisely because of its strong free cash flow.) Goldman doesn't seem to share this concern.

But then again, Goldman's not beating the market on its pharma picks, either.

Fool contributor Rich Smith owns shares of AstraZeneca, and has recommended it on CAPS. Speaking of which, you can find him on CAPS, publicly pontificating under the handle TMFDitty, where he's currently ranked No. 463 out of more than 170,000 members.

Becton, Johnson & Johnson, and Stryker are Motley Fool Inside Value picks. Teva Pharmaceutical Industries is a Motley Fool Global Gains selection. Johnson & Johnson is a Motley Fool Income Investor recommendation. Motley Fool Options has recommended a diagonal call position on Johnson & Johnson. The Fool owns shares of Johnson & Johnson, and Teva Pharmaceutical Industries. Alpha Newsletter Account, LLC owns shares of Johnson & Johnson. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (1) | Recommend This Article (8)

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On May 12, 2011, at 10:22 PM, weswood wrote:

    JNJ has increased it's dividend at an annualized 10% per year over the past decade. Don't leave this out of your analysis!

    If the dividend increases continue at the same rate in 5 years you'll be collecting ~5% dividends plus any capital appreciation. That's not too shabby.

    JNJ may not knock the socks off the S&P, but despite the recent recall troubles, you can sleep well at night knowing that your money is invested in one of the greatest American companies with one of the most shareholder-friendly management teams on the planet.

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